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Uncertainty Mutes Impact of Monetary, Fiscal Policy

Time and an agreement on taxes may restore businesses’ ‘animal spirits.’

It is popular these days to compare current hard times to the Great Depression. The temptation is easy to understand. Because the events of the 1930s convey high drama and not a little romance, they make a good lead for almost any article. Of course, there’s enough difference between these two events to render such links misleading from time to time, but one very fundamental and important parallel does exist. As in the Great Depression, the crisis of 2008-2009 muddled perceptions about how the economy works, how effective policy moves will be and how the economy will perform in the future. The attendant insecurity has fostered general reluctance in the business community and that has muted all economic responses, even to the best-conceived policies.

The extent of this muddling was evident in the recent election campaign. Still, through the fog, two basic narratives emerged: On the left of the political spectrum are the neo-Keynesians, led by columnist Paul Krugman. This group would ratchet up government spending and borrowing still more, to “jump-start,” in the popular phrase, the economy. On the right, apart from the bias against big government, the analytical focus seems to lean toward monetary policy. This group would have the Federal Reserve, the Bank of England, the European Central Bank and other central banks keep markets well supplied with liquidity, effectively greasing the wheels of commerce until more fundamental healing can occur. There is dispute within this camp as to the appropriate extent and duration of such monetary ease, but this general approach seems to be where the bulk of their analytical effort has gone.

Krugman and the neo-Keynesians have argued strenuously against worrying about the size of government or budget deficits. They contend that even higher levels of government borrowing and spending would foster enough growth ultimately to pay for themselves with increased tax revenue. Krugman and his colleagues, University of California at Berkeley economist Brad DeLong prominent among them, continue to argue this line despite the failure of the massive 2009 stimulus effort, either its inability to generate much economic acceleration or President Obama’s admission that there were not enough “shovel-ready” projects. Rather than being chastened by that failure, they claim that the effort, massive as it was, was insufficient. They point out that during the Great Depression, it took the truly massive spending triggered by World War II to get the economy going. So far Krugman & Co. have resisted the temptation to advocate declaring war.

The explanation for the failure of neo-Keynesian policy may have less to do with the amount of spending than with a caveat noted by Keynes. While he advocated government spending, he emphasized that government stimulus can only have an impact beyond itself when it inspires what he called the “animal spirits” of business people. In other words, government spending can only prompt a general recovery, according to Keynes, when business is willing to capitalize on it with its own spending and hiring. Unfortunately, the present environment of uncertainty and doubt has dampened such spirits. The same reluctance was evident during the Great Depression. In the present environment, the government has further dampened those spirits by vilifying business people and threatening to tax away much of the income they might gain from capitalizing on the government’s efforts. Little wonder, then, that the 2009 stimulus had no lasting impact, what economists call multiplier effects. The same problem raises doubts about Krugman’s demands for still more spending.

Curiously, this combination of tax threats and limited confidence may also explain why the monetary solution has failed thus far to get the economy back on track. Fed Chairman Ben Bernanke has poured huge amounts of liquidity into the system and, confronted with a muted economic response, has simply argued for more. Even the stock market has failed to respond fully. Though it’s up dramatically from its lows, its pricing still remains depressed compared with less risky assets, such as Treasury notes and high-grade corporate bonds. No doubt the confusion and concern about what might happen has also made business and the public reluctant to take full advantage of the ocean of liquidity offered by the Fed.

This problem is evident not only in the still disappointing state of the economy but in the benchmarks used by the Fed itself. Currency in circulation and bank reserves, two things the central bank controls directly, have surged under the influence of easy monetary policy. In the past two years, bank reserves have jumped 15.5% a year, and the so-called monetary base, which adds currency in circulation to measures of bank reserves, has increased at a 21.1% annual rate. But because the lack of confidence makes banks reluctant to lend and the public reluctant to borrow for either business or personal use, only a portion of these reserves has flowed into circulation. The broad M2 measure of money circulating in the economy, for instance, has grown only 7.9% a year during this time, faster than the economy, to be sure, but clearly slower than the Fed intends.

It would seem that time offers the only solution. Whatever tax policies eventually go into effect will presumably relieve the public and business community of uncertainty on that front. If the government ultimately takes more, at least companies and individuals will be able to plan and so are more likely to take advantage of either fiscal or monetary stimulus. The uncertainties over how the economy works will also resolve themselves in time. Even a slow-growing economy can reestablish in people’s minds a notion of what the future holds, whether accurate or not, and erase the lingering confusion that resulted from the shock of the financial crisis and the severe recession that followed it. In the meantime, the slow pace of advance will continue to dominate, with all the disappointment and frustration it brings.

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